The mortgage industry is in the midst of a liquidity problem. It is not as if there is not a lot of money out there it is that there is an enormous amount of doubt about the true value of mortgage backed securities.
I want to state unequivocally that this problem is 1) serious and 2) has a set of obvious solutions. The repercussions are that there are some very large entities which are going to have to take very large losses. Frankly, that is their problem. What is important is that 1) the losses get accounted for (I mean in the bookkeeping sense) and that 2) mortgage liquidity be reestablished.
Some Background
To understand what happened to Jumbo mortgage rates you need to understand the structure of the mortgage industry. It is a chain. You, the borrower, call me and I get you a loan. I get this loan funded through the lines of credit which my company RPM has. RPM sells your mortgage to an entity which is usually a large commercial bank. We get paid and pay back the credit line so that we always has a supply of cash. The folks who purchased that loan from us have assumed that they will be able to sell it through Wall Street to the final investor which is an entity such as a pension or hedge fund. It is at this stage that the process has stopped. The commercial banks which purchased Jumbo loans in the last month or so have found that no one want to buy them. That is the locus of the liquidity problem..
Rather than write a narrative about this I will attempt to explain what is happening the the format of theoretical Q&A's.
Q: What the heck happened to Jumbo mortgage rates?
A: They went up. Well, OK, they soared.
Q: What caused this?
A: In short no one at present wants to buy the securities which back pools of recently made Jumbo mortgages.
Q: Why?
A: Investors are in the unenviable position of having little idea of what some of their mortgage-backed security assets are worth because no one is making offers. The worst words in the industry are "no bid." It is hard to value something which no one is willing to buy. Then fact is that something is worth no more than the highest bidder is willing to pay for it.
Q: Why the distrust?
A: Investors no longer believe what they are being told regarding how to rate the risk associated with these pools. They no longer trust the debt rating companies. These are the same companies which rated corporate debt and subprime debt. They have lost their credibility. Note that this is happening just after the lack of confidence in debt rating for leveraged buy outs.
Q: But why?
A: People who buy fixed income securities are not looking to get rich they are looking to purchase assets whose return matches or exceeds inflation. When that cash flow stops they are quite upset. That cash flow and the underlying value of the securities backed by the mortgage is diminishing because more people than expected are late in their payments and more foreclosures are happening.
Q: How did this get so screwed up?
A: This is a problem created entirely by the mortgage industry most especially by the firms which securitize these mortgages. They made unrealistic assumptions and were too liberal in their guidelines. If you want you can pass the blame to the debt rating companies which gave unrealistically rosy ratings to this debt. If you think that there is really an "arm's length" relationship between the debt rating agencies and the Wall Street firms then I want some of what you are smoking.
Q: What exactly do you mean "too liberal?"
A: There are two focuses here:
1) loans were made to people who had bad credit without asking for any documentation to support their stated income. That was insane. Let me repeat: that was INSANE.
2) Jumbo loans for people who had no income documentation were made at rates that were unrealistically low.
Q: What can be done to fix this?
A: Simple:
Two parties need to act to fix the problem 1) the Fed and 2) the mortgage industry.
The Federal Reserve must (and will) continue to provide liquidity. It has the capability and knowledge of how to do this and is not influenced by the shortsightedness, stupidity and greed of Wall Street.
The mortgage industry must do two things:
1) No loans to folks with bad credit (<640 credit score) without full documentation that they at least have the potential to make the payment.
2) stated income A-paper (good credit) should be bumped up about 0.625% in RATE above full doc.
Q: Isn't that a bit extreme?
A: Yes but what we need is an extreme tightening of loan standards to restore liquidity to the mortgage backed security industry. We can work on getting the numbers right later.
Q: But Shouldn't the Fed Solve the Problem by Lowering Rates?
A: Absolutely, positively NO. It is imperative that the mortgage industry fix the structural problems and restore liquidity to mortgage backed securities. Changes in the Fed overnight rate will not affect the perception of the value of mortgage backed securities.
The role of the Fed in this situation is and will be to provide liquidity to banks. It can lower rates after the mortgage industry sets into motions some sensible plans for reestablishing liquidity.
Wall Street firms (the same ones which created the problem) are posturing the Fed. This is propaganda from Merrill-Lynch:
"According to Merrill Lynch, traders are speculating that the Federal Reserve will cut interest rates at an emergency meeting as soon as next week. Investors see the chances of a quarter-point reduction in the Fed's key rate on any day from Aug. 16 at higher than 50%, and the market appears to be pricing in a substantial risk that the Fed will be forced to do an emergency inter-meeting cut in August,' according to ML"
One thing I have found is that if Merrill-Lynch says something then you know that the opposite is true. To be more serious: what the Fed must do is exactly what it was doing Friday morning. That is providing liquidity. In fact before the Fed started pouring money into the system the free-market overnight Fed funds rate was 6%. They hammered it down to 5.25% - their target.
Fortunately ranting like that of Jim Cramer or ML is unlikely to affect the Fed.
Q: When Did This Start?
A: From my perspective this is something which started with the S&L problem in the late '80's when they had to go to Wall Street to sell their loans. Wall Street has taken over the lion's share of mortgage securitization and, apparently, done a poor job.
Q: Should FHLMC & FNMA be allowed to participate in the Jumbo market?
A: The underlying answer is "yes" because they have always done this correctly. Unfortunately they decided to screw with their accounting to deceive their stockholders about the value of their stock. It is important to understand that had nothing to do with the value of their mortgages. It had only to do with the value of their stock. Compare this to Krispy Kreme. I did not stop buying their jelly donuts because they cooked their books.
Unfortunately whatever relaxation of FHLMC/FNMA loan amounts has to go through Congress which may be the only entity on the planet more dysfunction than the mortgage industry at present. With what seems like 5% of Congress running for President there is a massive dysfunctionality there. Cooperation in the mutual interest of the public seems to be not as important as blaming the other party. (In fact the Presidential debates could be replaced by a photograph of all of the candidates each dressed in an "I'm With Stupid" T-shirt.)
Also, it is not self-evident but there is a de facto group of Wall Streeters who simply want to undermine FHLMC/FNMA because they want that agency action and the associated profit.
The fact is that FHLMC/FNMA have not come out from under the doubts generated by their accounting malfeasance and they picked a damn bad time to do that!
A few final comments:
What markets like the least is uncertainty. What we have now is UNCERTAINTY. Inability to value assets renders business dysfunctional.
You may know better, but I also believe loans were made to people using ARM's just to qualify based on the assumption that if rates went up, housing prices would stay up and the borrower could walk away with a small profit. These were people who based on doucmented income (W2's etc) would qualify for $x on a 30 year loan but bought a house which was much more than $x, as ARM rates were lower. This greed caught up to them and they have loans they cannot service and houses worth less than they bought them.
Posted by: Ashok | August 10, 2007 at 12:46 PM
Regarding ARMs:
Most all investors are now requiring that ARMs be underwritten at the fully indexed rate (present value of the index plus the margin). You are correct in pointing out that underwriting at start rate was another example of shortsighted lending.
Posted by: Dick Lepre | August 10, 2007 at 01:24 PM